Do Economists Really Know What They’re Talking About?

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. . . . Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.—English economist John Maynard Keynes (1883-1946)

Almost everyone wants the world's governments to do more to revive ailing economies. No one wants a "double dip" recession. The Group of 20 Summit in Toronto was determined to avoid one. In major advanced countries—the 31 members of the Organization for Economic Cooperation and Development—unemployment stands at 46.5 million people, up about 50 percent since 2007. It's not just that people lack work. Lengthy unemployment may erode skills, leading to downward mobility or permanent joblessness. But what more can governments do? It's unclear.

We may be reaching the limits of economics. As Keynes noted, political leaders are hostage to the ideas of economists—living and dead—and economists increasingly disagree about what to do. Granted, the initial response to the crisis (sharp cuts in interest rates, bank bailouts, stimulus spending) probably averted a depression. But the crisis has also battered the logic of all major theories: Keynesianism, monetarism and "rational expectations." Economics has become the shaky science; its intellectual chaos provides context for today's policy disputes at home and abroad.

Consider the matter of budgets. Would bigger deficits stimulate the economy and create jobs, as standard Keynesianism suggests? Or do exploding government debts threaten another financial crisis?

The Keynesian logic seems airtight. If consumer and business spending is weak, government raises demand through tax cuts or spending increases. But in practice, governments' high debts impose financial and psychological limits. The ratio of government debt to the economy (gross domestic product) is 92 percent for France, 82 percent for Germany and 83 percent for Britain, reports the Bank for International Settlements in Switzerland.

This means that the benefits of higher deficits can be lost in many ways: through higher interest rates if greater debt frightens investors; through declines in private spending if consumers and businesses lose confidence in governments' ability to control budgets; and through a banking crisis if bank capital—which consists heavily of government bonds—declines in value. There's a tug of war between the stimulus of bigger deficits and the fears inspired by bigger deficits.

Based on favorable assumptions, the Obama administration says its $787 billion "stimulus" program created or saved up to 2.8 million jobs. This might be. Lenders haven't lost confidence in U.S. Treasury bonds. Interest rates on 10-year Treasurys are just over 3 percent. But in Europe, financial limits have bitten. Greece's huge debt (debt-to-GDP ratio: 123 percent) resulted in a steep rise of interest rates. Germany and Britain are debating plans to cut their deficits to avoid Greece's fate.

That's lunacy, writes Martin Wolf, chief economic commentator for the Financial Times. Concerted austerity may destroy the recovery. Exactly, echoes Nobel Prize-winning economist and New York Times columnist Paul Krugman, who argues that the U.S. economy needs more stimulus and bigger deficits. "Penny-pinching at a time like this . . .," he writes, "endangers the nation's future."

Not so, counters Harvard economist Ken Rogoff. President Obama's stimulus package may have "helped calm the panic" in 2009, but boosting spending now—with federal deficits exceeding $1 trillion—raises "the risk of having a debt crisis down the road." Deficits should be gradually trimmed, he argues.

Indeed, some economists believe that budget cutbacks can stimulate economic growth under some circumstances. A study by economists Alberto Alesina and Silvia Ardagna found that budget cutbacks in wealthy countries often had an expansionary effect when spending reductions, not tax increases, were emphasized. Presumably, these budget plans favorably influenced interest rates and confidence without weakening the incentives to work and invest.

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Like textbook Keynesianism, "monetarism" has also suffered in its explanatory power. This theory holds that big injections of money ("reserves") into the banking system by the Federal Reserve should lead to higher lending, higher spending and—if large enough—inflation. Well, since the summer of 2008, the Fed has provided about $1 trillion of reserves to banks, and none of these things has happened. Inflation remains tame, and outstanding bank loans have dropped more than $200 billion in the past year. Banks are sitting on massive excess reserves.

There's a great deal economists don't understand. Not surprisingly, the adherents of "rational expectations"—a theory that people generally figure out how best to respond to economic events—didn't anticipate financial panic and economic collapse. The disconnect between theory and reality seems ominous. The response to the initial crisis was to throw money at it—to lower interest rates and expand budget deficits. But with interest rates now low and deficits high, what happens if there's another crisis?